Tilburg University
Finance, growth and social fairness
Sucre Reyes, M.A.
Publication date:
2014
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Citation for published version (APA):
Sucre Reyes, M. A. (2014). Finance, growth and social fairness: Evidence for Latin America and Bolivia. CentER, Center for Economic Research.
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Finance, Growth, and Social Fairness:
Evidence for Latin America and Bolivia
Finance, Growth, and Social Fairness:
Evidence for Latin America and Bolivia
Proefschrift
ter
verkrijging
van
de
graad
van
doctor
aan
Tilburg University op gezag van de rector magnificus,
prof.dr. Ph. Eijlander, in het openbaar te verdedigen ten
overstaan van een door het college voor promoties
aangewezen commissie in de aula van de Universiteit op
maandag 30 juni 2014 om 14.15 uur door
Maria Antonieta Sucre Reyes
Promotores:
Prof. dr. H.G. van Gemert
Prof. dr. A.C. Meijdam
Overige leden:
To my parents, German and Graciela.
To my husband, Wilco and my children, Femke, Maaike, and Lex.
Acknowledgments
The conclusion of this thesis not only means reaching a titanic academic goal, but it also represents the closing of an important and challenging period of my life. Through these years of my doctoral project I have been trying to reach a balance between academic, work, and personal goals. I am quite fortunate for all that I have learned about economics and life during this (long) time, but even more privileged for all the precious moments that I have experienced as the mother of three lovely children.
I am deeply grateful to my supervisors, Prof. dr. Henk van Gemert and Prof. dr. Lex Meijdam. Thanks to all their support, patience, and guidance this project is now reaching its conclusion. Being their student has been a great honor. I appreciate and admire them not only for their professional profiles but also who they are as persons. Their constructive and wise minds have encouraged this thesis through all its stages and have also helped when the time came to confront difficulties and challenges. They have come alongside me in bringing to fruition this huge academic goal but also indirectly in understanding and supporting my personal goals.
I would also like to thank to Prof. dr. Jeffrey James, who has been present throughout my post-graduate education. First he supervised my Master’s thesis, and after some years in the last stages of my PhD project he has served as the advisor for the last chapter of the present dissertation. During my last stays at Tilburg University I could always pass by his office to have a chat, and even when I have been in Bolivia he has been always kind and helpful by replying promptly to my e-mails, giving me many constructive comments and suggestions. Lastly, I am grateful to him for accepting a seat on my PhD committee.
My thanks also to the other members of my committee: Prof. dr. Thorsten Beck, Prof. dr. Robert Lensink, and Prof. dr. Clemens Kool. I appreciate their interest in my work and their insightful comments on my manuscript. Their questions and suggestions have helped a lot in improving the thesis. Each committee member contributed in his own way by commenting from his own perspective. During my master and doctoral program I had already met them through several of their publications, and it has been great to have them in person as my committee. I am proud to have such a prestigious group of evaluators.
Tilburg University provided a great research environment, and I would like to thank the staff and faculty members for their kindness and assistance. At the beginning and in the process of my research, I have knocked on the office doors of people such as Prof. dr. Vasso Ioannidou, Prof. dr. Arthur van Soest, and Prof. Jan van Ours. I am grateful that they gave me the time for a talk or replied to my e-mails when I was far away from The Netherlands. In the last years of my program I have also received the support of various staff members at Tilburg University. I am particularly grateful for the assistance and warm encouragement of Dr. Bertha Vallejo, Project Manager at the Tilburg School of Economics and Management (TiSEM). She has arranged various administrative and logistic issues related to my PhD thesis during the last 4 years. Neither will I forget the sympathy and assistance of some office managers, such as Ank, Loes, Anja, Corine, Yvone and Nicole.
(teaching) and family duties. Therefore, I have also had the support and encouragement of some people in Bolivia to whom I would also like to express my gratitude.
I want to thank Dr. Carmen Ledo, the coordinator of the Center of Planning and Management (CEPLAG) at Universidad Mayor de San Simon in Cochabamba, Bolivia. For more than 3 years I have been a PhD candidate fellow at this research center. She has given me her institutional support and practical advice, and she has encouraged me to go on in difficult situations when I felt like “throwing in the towel.” She has provided me a work space at the CEPLAG and has been available in her office for a talk even after my fellowship position finished in the center. Her optimism and confident personality is something that always infused me with positive energy and hope.
Special and heartfelt thanks to my husband for pushing me to pursue this goal. He was the one who persuaded me to apply for the doctoral program at Tilburg University. He always believed in me, even when I felt like digging a hole and I had no hope in my PhD project. He also had to tolerate many times my bad mood when I felt frustrated or tired. His typical easygoing and positive approach to life helped me to convince myself that all was doable or fixable. These years have not been an easy ride; as a married couple and being parents of three children, we have had to confront several challenges and obstacles. I feel that we both learned a lot about life and strengthened our commitment to each other and to our family.
I would like to express my gratitude to my parents for their unconditional support in this period of my life and for always being for me during these years. They have always been the cornerstone of my life, supporting my choices and advising me with their parental wisdom. Since I was a small child I have seen in them the best example of perseverance and effort, and at the same time a model of loving, dedicated parents. They did their best to not only give me a good education but also to teach me what is really valuable in life. ¡Gracias, pa y ma, ustedes siempre serán mi adoración y mi fuente inagotable de inspiración!
I would also like to offer my special and warm thanks to my three children. During these years they provided unforgettable and unique moments. Although there were also difficult moments to face with them as a mother, they very often made me feel like the happiest woman on earth. They have been born and grown up with their mother trying to achieve her professional challenges while at the same time trying to give them the number one place in her life. I am very grateful that God blessed me with such lovely children. They are one of the best things in my life, the storm and the rainbow of my existence. In the last few years, despite their young ages they have also been my personal coaches, cheering me up with their magical encouraging words or even by sharing their smiles with me.
My two brothers and my sister also deserve my gratitude. They have always been an important part of my life. Although they did not exactly understand why and what I was doing as a PhD student, they often supported me with a word and their caress as well as sometimes covering my absences with my children. On various occasions I was able to concentrate on my work and my thesis duties knowing that my children were in the best hands. ¡Gracias por todo, hermanitos, los quiero mucho!
I am also grateful to my parents in law. They believed in me and supported me with their caress and positivism.
Contents
Chapter 1
Introduction………..……….……….1
Chapter 2
Does financial development lead to economic growth and reduce inequality in Latin
America and the Caribbean? ... 5
Abstract ... 5
2.1 Introduction ... 6
2.2 Theoretical Considerations ... 9
2.2.1 Theoretical considerations regarding the finance-growth relationship ... 9
2.2.2 Theoretical considerations regarding the finance-inequality relationship ... 15
2.3 Empirical Evidence Review ... 16
2.3.1 Empirical evidence on the finance-growth relationship ... 17
2.3.2 Empirical evidence on the finance-inequality relationship ... 21
2.4. Growth, Inequality, and Finance in Latin America and the Caribbean ... 22
2.5 Methodology and Data ... 31
2.6 Results and Discussion ... 35
2.6.1 Financial development and economic growth ... 36
2.6.2 Financial development and inequality ... 44
2.7 Conclusions ... 47
References ... 49
Annexes ... 55
Chapter 3
Access to finance, growth, and poverty: An empirical analysis for Bolivia……...…95
Abstract...95
3.1 Introduction...96
3.2.1The challenge of measuring access to finance...103
3.2.2 Microfinance and the poor...106
3.2.3 Country case empirical evidence on the finance-growth and finance-poverty
relationships...107
3.3 Some Considerations about the Bolivian Financial System...115
3.3.1 The structure of the financial system...115
3.3.2 From financial repression to financial liberalization...118
3.3.2.1 The stage of financial repression before the application of the New
Economic Policy...119
3.3.2.2 The New Economic Policy and financial liberalization...121
3.3.3 The microfinance miracle...124
3.4 What Data Say about Access to Finance in Bolivia...129
3.4.1 Recent regulatory measures related to access to finance...133
3.5 Methodology and Data...133
3.6 Results and Discussion...141
3.6.1 Access to finance and economic growth...142
3.6.2 Access to finance and poverty...147
3.7 Conclusions...150
References...152
Annexes... ...159
Chapter 4
Alternative financial access mechanisms in Bolivia: The promising role of value chain
finance ... 165
Abstract ... 165
4.1 Introduction ... 166
4.2 Review of Related Literature ... 170
4.2.1 Microfinance, rural and agricultural (farm) finance ... 171
4.2.2 Main aspects of global commodity chains ... 173
4.2.3 Finance and global value chains: The promising role of value chain finance
in addressing access to finance ... 175
4.2.3.2 The role of foreign direct investment in access to value chain finance ... 180
4.2.3.3 The roles of trust and social capital in access to finance ... 182
4.2.4 Some main characteristics in the financing of small and medium firms ... 183
4.2.4.1 The determinants of financial obstacles for small and medium
firms: International trends ... 183
4.2.4.2 Access to finance and firm innovation ... 184
4.2.4.3 The role of trade credit ... 184
4.3 Methodology and Data ... 185
4.4 Main characteristics of the dairy value chain in Cochabamba, Bolivia ... 187
4.5 Value Chain Finance in the Dairy Chain in Cochabamba, Bolivia ... 194
4.5.1 Main value chain financial mechanisms ... 194
4.5.1.1 Direct value chain financial mechanisms... 194
4.5.1.2 Indirect value chain financial mechanisms ... 197
4.5.2 Governance, FDI, upgrading and value chain finance... 198
4.5.3 The role of social capital on value chain finance ... 201
4.5.4 Evaluating the impact of a value chain financial access facility on the
farmer segment ... 203
4.5.4.1 Econometric results ... 204
4.5.5 More about finance along the segments of the dairy chain in Cochabamba ... 206
4.5.5.1 Milk farmer segment ... 206
Chapter 1
Introduction
Over the last two decades, the role of finance in promoting economic growth and social fairness has received increasing attention in the economic literature. In the early 1990s King and Levine came up with a new and rigorous model to assess this relationship. Their approach was based on three components: endogenous growth theory, a modern view of financial intermediation, and advanced econometric techniques. Numerous empirical studies have appeared since then to estimate the impact of financial development on economic performance in terms of output, capital accumulation, productivity, and income distribution. In the beginning cross-country regressions were dominant, but later sector and industry level studies were carried out as well. Moreover, more rigorous econometric tools were adopted to shine a light on causality, and endogeneity and measurement problems were addressed by setting up large world-wide datasets. Levine’s seminal chapter in the Handbook of Economic Growth (2005) presented an excellent overview of the stance of the literature. Meanwhile, researchers at the World Bank drew attention to financial access as an important mechanism driving both the relationship between finance and growth and the relationship between finance and poverty. As a result, the profession continued investigating the “finance and growth nexus” while incorporating this comprehensive concept. Next, the crisis arrived. A new and deeper perspective on the role of finance gradually emerged that mitigates the previous appraisals and policy recommendations. This process of reevaluating the optimal size of a financial system is still fresh and far from being conclusive.
An important limitation of the mainstream research on the finance and growth linkages is that most empirical investigations rely predominantly on general evidence based on international, pooled data sets. A major lesson of financial liberalization experiences worldwide, however, is the necessity for economic and financial policies to be based on a careful consideration of country characteristics. Indeed, some of the newest studies confirm that the impact of finance differs across regions and across countries and therefore stress the need for empirical knowledge at the regional and country case level. This thesis takes this need seriously.
Our case study centers on Bolivia, a country for which the relationship between finance, growth, and social fairness turns out to be particularly important. The country exhibits one of the lowest growth rates in the region and is seen as one of the poorest and most unequal countries in Latin America and the Caribbean. Poverty and inequality are not only deeply rooted in the country but they are also among the most distinctive features of the region. Currently, Latin America is regarded as the most unequal in terms of income and the fourth poorest region in the world (World Bank, 2012). In general, economic growth in Latin American countries has not met expectations, regardless of significant institutional reforms and an inherent potential to fare better. Consequently, the identification of factors that would promote economic growth and social fairness in Bolivia and the region becomes transcendental and necessary.
Moreover, the goal of this research is to conduct an integral investigation that does not rely only on macroeconomic evidence (at the regional and country case level) but also uses microeconomic evidence regarding the role of finance in a value chain context.
Throughout the thesis, different dimensions of finance such as financial depth, access to finance, and institutional diversification have been taken into account. Several of these aspects of finance have just recently been studied in the empirical literature. In this respect, observing the limited access to finance for certain agents in Bolivia – in particular, small-sized firms and rural and poor households – we have also considered value chain finance as an important alternative for making financial services accessible.
A key element of our work relates to the indicators of access to finance. The few attempts to measure this aspect of finance are very recent and sadly have significant limitations. One of these limitations is that they do not take into account the financial services supplied by non-bank deposit institutions. In this respect, it is important to realize that non-bank regulated and non-regulated deposit institutions account for a significant share of the financial system in countries such as Bolivia. Therefore, it was necessary to include this type of financial institutions when preparing and analyzing the financial access proxies.
As stated earlier, another innovative element of this dissertation is associated with value chain finance. With traditional and new sources of credit (i.e. microcredit) being limited or even closed to low-income and rural agents, value chains are appearing as an alternative to provide access to finance. Value chain finance breaks with the prerequisite of hard collateral to access credit. The existent business relationships between the chain actors replace the need for hard collateral. When a buyer with a reputation as a creditworthy purchaser or processor is willing to vouch for its suppliers (farmer or producers), even small agents become more attractive clients to financial institutions. As one might expect, limitations to credit provision are fewer, the terms and services are better, and the loans reflect the cash flow pattern of the business activities of the actors that are part of the value chain (UNCTAD, 2004; USAID, 2005; Conn et al., 2010).
Three comprehensive studies form the structure for this thesis. First, following this introduction, Chapter 2 reviews the large amount of theoretical and empirical work on the finance-growth relationship and the finance-inequality relationship. Additionally, given the economic and social peculiarities of Latin America and the need for a fresh look at the evidence (De la Torre, 2012), we examine and estimate both relationships for this region. With this purpose in mind, cross-sectional and panel data analyses are executed covering data on financial development, economic growth and inequality for Latin American and Caribbean countries. Our main findings suggest that financial development matters a lot for economic growth in the region. In the case of inequality, the evidence is mixed and even looks contradictory. On the one hand, cross-sectional outcomes support the hypothesis that financial development reduces inequality, but on the other hand, panel data results indicate the contrary. Therefore, it is likely that financial development reduces income inequality in the very long run while it raises inequality in the medium and long run. It is also possible that when evaluating the role of finance on growth and social fairness, other dimensions of finance such as access may be more important than depth or efficiency.
regression equations. After presenting a contextual analysis of Bolivian financial intermediation, a cross-sectional analysis is executed over more than 300 Bolivian municipalities, covering proxies of access to finance as the explanatory variable, indicators of economic growth and poverty as the dependent variable, and a set of control variables. Among these control variables that influence growth or poverty – apart from financial access – geographical conditions are considered as a newly developed control variable. Our main findings indicate that access to finance is a significant factor in spurring economic growth and poverty reduction in Bolivia. Additionally, the contextual and econometric analyses highlight the role of microfinance institutions in the promotion of growth and the alleviation of poverty in the country. Among these MFIs, it is worth stressing the role of nongovernmental organizations (NGOs) and other semiformal institutions. Moreover, the Bolivian experience with microfinance as well as the historical evolution of its financial system from financial repression to financial liberalization suggests that the role of the government in building an effective and inclusive financial system should focus on regulation and on promoting the supply of financial services rather than on ownership and direct control.
The main findings of Chapter 3 support the hypothesis that in developing countries such as Bolivia, inclusive finance initiatives such as microfinance and financial intermediary diversification have had a positive effect on economic growth and poverty reduction. Yet we must also recognize that financial access is still very limited for many agents such as small and micro-sized firms and also rural and poor individuals in Bolivia. Therefore, when searching for alternatives to make finance accessible for these types of agents, Chapter 4 stresses the importance of value chain finance as an alternative to enable and extend financial access for those actors (mainly micro, small, and rural agents) who are usually left unserved by the financial system.
In Chapter 4, after reviewing the current diverse literature related to the topic, our original empirical evidence looks at the case of the dairy chain of Cochabamba, Bolivia. In this value chain case, after identifying its main characteristics we find which types of financial mechanisms are actually available to value chain actors. In general, access to finance appears to be an important factor in determining the upgrading of the whole chain and particularly in improving the situation of poor actors such as milk farmers. Sustaining this statement, based on original panel data evidence we found a positive effect of expanding access to credit – through an indirect value chain finance instrument – on the production patterns of milk farmers. Our case study analysis also reveals that poor actors – mainly small milk farmers – have very remote chances of accessing finance if they are not part of a value chain. The contractual relationship that farmers have with a large or “creditworthy” actor appears to be the “magical key” that enables certain financial access mechanisms for them. Therefore, direct and indirect value chain financial mechanisms act as a way to access finance. However, our case study also identifies some limitations of value chain finance, indicating the necessity to strengthen indirect value chain finance by means of the financial system. Additionally, our case study analysis also reveals the important influence exerted by value chain governance and social capital on financial access for poor actors of the value chain.
The results of this dissertation have implications for the design of financial and social policies at the regional and country case level. In the case of Latin America and the Caribbean, our results confirm that a more efficient financial system will have a positive effect on economic growth. This finding is still consistent with post-crisis empirical literature (Arcand, Berkes, & Panizza, 2001; Cecchetti & Kharroubi, 2012), which predicts that above a certain level, financial development can become a drag for the economy. As far as we know, financial systems in Latin America are far from being “too large.” Therefore, it is likely that financial development continues to be a powerful pro-growth instrument for the region.
Our case study of financial access in Bolivia shows the positive effect of a more inclusive and diversified financial system, not only in terms of growth but also in terms of social fairness. In this sense, it is important that the country keeps advancing on this path of making financial services more accessible to all. As a contribution to this process, the role of government should focus on regulation and stimulation, but also on the promotion of competition among financial institutions.
As stated earlier, it is evident that access to financial services is still limited in Bolivia. Therefore, value chain finance appears to be an alternative in these cases. However, in order to take advantage of these mechanisms it is important to promote the participation of these agents in value chains. Additionally, since value chain finance is highly related to the mainstream financial system, it is necessary for financial institutions to take a value chain approach. Traditional financial intermediaries offer a fixed set of loans without considering that agents are often part of a value chain. In this sense, bank and non-bank institutions should understand that the risk associated with a particular actor (i.e. small producer) can be estimated by regarding the risks and the competitiveness of the chain in which the agent is participating.
Furthermore, our case study shows that in operational terms, farmer associations play an important role in both direct and indirect value chain finance. In the case of indirect finance, the associations act as a kind of intermediary between the formal financial institutions and the farmers. Therefore, it is important to promote the formation and consolidation of “efficient farmer associations.”
Finally, we have also found evidence that foreign direct investment can have not only positive “spillover” effects on the economy in terms of output, employment, technological innovation, and efficiency, but also in terms of promoting alternative mechanism of finance for micro, small and medium-sized firms, as is the case of value chain finance. In this sense, it is essential as part of pro-growth and pro-social fairness policies to promote an attractive and proper scenario for foreign direct investment in the country and the region.
References
Arcand, J. L., Berkes, E., & Panizza, U. (2011). Too much finance? The Graduate Institute. IMF & UNCTAD. Cecchetti, S., & Kharroubi, E. (2012). Reassessing the impact of finance on growth. Bank for International Settlements (BIS) - Working Papers, No. 381.
Coon, J., Campion, A., & Wenner, M. (2010). Financing agriculture value chains in Central America. Washington, D.C.: Inter-American Development Bank.
De la Torre, A., Ize, A., & Schmukler, S. (2012). Financial development in Latin America and the Caribbean: The road ahead. Washington, D.C.: World Bank Publications 2012.
Levine, R. (2005). Finance and growth: Theory and evidence. In P. Aghion & S. Durlauf (Eds.), Handbook of Economic Growth (pp. 865-934). Elsevier.
UNCTAD (2004). Financing commodity based trade and development: Innovative agriculture financing mechanisms. Report prepared by the UNCTAD secretariat for the Expert Meeting on Financing Commodity-Based Trade and Development: Innovative Financing Mechanisms. Geneva, 16–17 Nov. 2004.
USAID (2005). Value chain finance. RAFI Notes 2. United States Agency for International Development. Washington, D.C.
Chapter 2
Does financial development lead to economic
growth and reduce inequality in Latin
America and the Caribbean?
1
Abstract
Over the last 20 years, the role of finance in promoting economic growth and reducing inequality has received increasing attention in the economic literature. Some of the latest studies in this area suggest that its impact differs across regions and types of economies (Goaied, 2010; Barajas et al., 2012; Andersen et al., 2012), giving rise to a need for more specific empirical knowledge at the regional and single country levels. Additionally, it is evident that the last financial crisis has spawned a skeptical assessment of the finance-growth nexus. The present paper reviews the bulk of empirical work on the relationships between finance and growth and between finance and inequality. Additionally, given the economic and social peculiarities of Latin America and the need for a fresh look at the evidence (De la Torre, 2012), we examine both relationships for this region of the world. For this purpose, cross-sectional and panel data analysis are conducted using data of proxies of financial development, economic growth, inequality, and other control variables for Latin American and Caribbean countries. The main findings suggest that financial development matters for economic growth in the region. The results seem robust to different measures of financial development and sets of control variables. In the case of inequality, the evidence is mixed and even appears contradictory. On the one hand, cross-sectional results support the hypothesis that financial development reduces inequality, and on the other hand, panel data analysis suggests the opposite. Therefore, it is possible that financial development acts as an income equalizing factor in the very long term, while it raises inequality in the medium and even long term. It is also likely that at the moment of evaluating the role of finance on growth and social fairness, other dimensions of finance such as access to and diversification of financial services (for a given level of depth) should be more relevant. In this way, there is the necessity to consider and evaluate other aspects of the financial system that are at least as important as financial development.
1
An earlier version of this chapter was presented at the international conference “Tercer Encuentro de Economistas de
Bolivia” that took place in Cochabamba, Bolivia on 7 and 8 October 2010 and was organized by the Central Bank of Bolivia.
2.1 Introduction
The relationship between financial development and economic growth has remained an important issue of economic debate. The pioneering contributions concerning this relationship are from Schumpeter (1912), Goldsmith (1969), McKinnon (1973), and Shaw (1973). A significant number of theorists, starting with Schumpeter, have emphasized the role of financial development in better identifying investment opportunities, reducing investment in liquid but unproductive assets, mobilizing savings, boosting technological innovation, and improving risk taking. However, not all are convinced about the importance of the financial system in the growth process. According to Lucas (1988), economists are “badly over-stressing” the role of financial factors in economic growth. Robinson (1952) synthesized the view of those who are skeptical about the role of finance as a growth factor when she wrote, “Where enterprise leads, finance follows.” In this view, economic growth creates demands for particular types of financial arrangements, and the financial system responds automatically to these demands (Bhattacharya & Sivasubramanian, 2003; Zang & Kim, 2007; Asongu, 2011).
Among other important and recent theoretical-empirical studies that have stressed the role of finance on growth are those by McCaig (2005), Levine (2005), Bertocco (2008), Dawson (2008), Brezigar, Coricelli, and Masten (2008, 2010), Lee and Islam (2008), Vaona (2008), Acaravci, Ozturk, and Acaravci (2009), Beck, Büyükkarabacak, Rioja, and Valev (2009), Caporale, Rault, Sova, and Sova (2009), Dabos and Williams (2009), Ghimire and Giorgioni (2009), Kıran, Yavuz, and Güriş (2009), Yay and Oktayer (2009), Antonios (2010), Goaied and Sassi (2011), Arcand, Berkes, and Panizza (2011), Asongu (2011), Bezemer (2011), Demetriades and Rousseau (2011), Ductor and Grechyna (2011), Fowowe (2011), Hassan (2011), Rachdi and Mbarek (2011), Andersen, Jones, and Tarp (2012), Barajas, Chami, and Rezal (2012), Cecchetti and Kharroubi (2012), Oluitan (2012), and others. Specifically, one of the latest works of Levine refers to theoretical models showing that financial intermediaries and markets may arise to mitigate the effects of information and transaction costs. Therefore, financial systems may influence saving rates, investment decisions, technological innovation, and hence long-term growth rates. Also, Levine makes a critical review of empirical studies on finance and growth, concluding that we are still far from a definitive answer to the questions: Does finance cause growth, and if it does, how? (Levine, 2005)
In the last few years, after the recent crisis, concerns have increased that some countries may have financial systems too large in comparison with the size of their domestic economies and that in that situation more finance will give place to less growth. Specifically, the hypothesis that above a certain level financial development would become a drag for the economy is reflected in the work of Arcand et al. (2011), Ductor and Grechyna (2011), and Cecchetti and Kharroubi (2012). However, it is important to mention that this statement is not new. Already in the decade of the 1970s, studies such as those by Minsky (1974) and Kindleberger (1978) refer to this possibility. Later, other authors such as Easterly et al. (2000) and Rajan (2005) (as cited in Arcand, Berkes, & Panizza, 2011) also consider this hypothesis. Easterly et al. (2000) show that there is a convex and non-monotone relationship between financial development and economic growth, and even their estimations suggest that output volatility starts increasing when credit to the private sector reaches or surpasses 100% of GDP. Rajan (2005) also touched on the vulnerabilities of financial development, suggesting that too much finance would increase the probability of a “catastrophic meltdown” (Arcand et al., 2011).
the need for cross-country econometric analysis to be complemented by more broad-based empirical evidence derived from regional (i.e. Latin America and the Caribbean) and single country studies. Specifically, recent studies such as the ones of Lee and Islam (2008), Dabos and Williams (2009), Goaied (2010), Barajas et al. (2012), and Andersen et al. (2012) suggest that there is considerable heterogeneity in the effect of financial development across regions and countries. Therefore, there is an urgent necessity for empirical evidence at the regional and single country levels.
As we will show in our review of empirical literature (Section 2.3), another important limitation of the existing empirical research on finance and growth is the concentration on the single objective of economic growth. But what if financial development benefits only the rich and powerful people? In comparison with the studies regarding the link between finance and economic growth, there has been little research about the relationship between financial development and inequality (see Annexes 2.1 and 2.2). Considering “socially fair development,” it is important to take into account that financial development could have distributional and poverty impact implications.
In this respect, Demirgüç-Kunt and Levine (2009) argue that economists underestimate the potentially important effect of finance on inequality. The authors note that while a growing body of theoretical and empirical research suggests that financial sector policies would have a first order impact on inequality, still many economists perceive financial markets’ imperfections as fixed. Even in some theories, credit constraints are erroneously seen as exogenous. Therefore, with finance regarded as unchanging, some theoretical and empirical models concerning inequality (i.e. Becker & Tomes, 1979; Galor & Zeira, 1993; Mookherjee & Ray, 2003)2 proceed to consider how human capital, fertility rate, inflation, and other variables affect inequality, giving rise to policy recommendations that ignore finance as an additional equalizing instrument. It is evident that in reality, finance is not unalterable and that diverse dimensions of financial systems such as depth, access, and diversification would have a pronounced effect on inequality.
Despite inequality and poverty being very different things, there is evidence that inequality matters are related with poverty. In this sense, it is important to mention that for a given level of mean income, greater inequality generally means greater poverty or, even worse, that for a given rate of growth in mean incomes, greater inequality usually implies a slower rate of poverty reduction. In this respect, Beck, Demirgüç-Kunt, and Levine (2007) show that financial development may affect the poor by means of two channels: aggregate growth and changes in the distribution of income. Additionally, there is evidence that inequality is associated with greater prevalence of conflict and violence and may impair an economy’s ability to respond effectively to macroeconomic shocks (De Ferranti, Perry, Ferreira, & Walton, 2004).
Evidence also shows that poverty and inequality can undercut growth itself. So inequality not only prevents the poor from benefiting from growth but can also lower economic prosperity for a whole country and region. Nevertheless, taking these financial frictions as given and ignoring incentive effects, some recommendations to reduce income inequality only suggest public policies redistributing income from the rich to the poor. Much less emphasis has been put on financial development policies as a way to reduce income inequality (Beck, Demirgüç-Kunt, & Levine, 2007).
In reference to this last issue, although theoretical models make distinct predictions about the relationship between financial sector development and income inequality, little empirical research has been conducted to compare their relative explanatory power (Clarke, Xu, & Zou, 2003; Demirgüç-Kunt & Levine, 2009). Part of this is a data problem, since inequality indicators are not available for all countries and the time period covered by datasets is relatively limited. Additionally, it is also important to consider the presence of data inconsistencies in most of the cross-country datasets about inequality. Widely known and consulted international datasets such as Wider-UNIDO, Deininger
2
and Squire, and Dollar and Kraay have important quality deficiencies. The main shortcoming relates to the fact that despite all the data resources measuring inequality, the definitions vary among and within countries. Therefore, these different definitions would compromise comparability between cases and bias results estimations (Lubker, Smith, & Weeks, 2002).
The issue of finance in the Latin American and Caribbean region is particularly interesting and important if we note that practically all their countries are considered to be developing economies. Economic growth in Latin American countries has not met expectations, regardless of significant institutional reforms and their inherent potential to fare better. Poverty and income inequality remain high and deep-rooted to the extent that the region is regarded as the most unequal in the world in terms of income. Indeed, one of the most distinctive features of Latin America and the Caribbean is its high degree of inequality. Few economic and social variables are as closely associated with the region as inequality. Living standards vary markedly among citizens both between and within countries. The region was already characterized by sharp income inequality before the debt crisis and structural reforms of the 1980s and 1990s, when inequality rose in most countries. However, it seems that around 2000, the rising trend in inequality came to a halt in some Latin American countries such as Brazil, Bolivia, Argentina, Venezuela, Peru, Chile, and El Salvador (De Ferranti et al., 2004; Lustig, Lopez-Calva, & Ortiz-Juarez, 2011).
In a certain way, many political and economic experiments that took place in the region in the last century have been perhaps motivated by the search for a model that would reduce inequality and poverty. Some of these political and economic efforts consisted of waves of heavy government intervention and protectionism, followed by privatizations and market-oriented reforms, followed recently in some countries by the undoing of market reforms and the nationalization of natural resources. Among the many reforms implemented in developing countries in the last 30 years, the liberalization and expansion of financial markets has been prominent. Latin American and Caribbean economies practiced "financial repression" policies for around four decades, from the 1940s to the 1970s. There was a significant government presence in the financial system reflected in state-owned financial institutions with directed lending to chosen sectors and interest rate ceilings with the purpose of raising investment and growth. Financial liberalization came at the end of the 1970s expanding financial markets in the region. However, compared to other developing regions, even in a scenario of financial liberalization, financial indicators have lagged behind those of other developing regions such as East Asia (Canavire & Rioja, 2009).
While the overall region is on its way to meeting the Millennium Development Goals relating to human development, it lags behind on achieving the poverty goal, as does Sub-Saharan Africa (Saavedra & Arias, 2005). Therefore, it is crucial for the region to identify and analyze factors that could promote economic growth and reduce income inequality and poverty (Blanco, 2007).
Given this necessity, the main goal of the present paper is to analyze the effect of financial development on economic growth and income inequality in the Latin American and Caribbean region. Toward that end, most of the existing empirical evidence published in the period 1993-2012 was reviewed with a focus on both relationships (finance-growth and finance-inequality). Additionally, since very few empirical analyses use samples that pool countries of the same region and even fewer studies focus on the Latin American region, we attempt to approach empirically both relationships for the case of Latin America and the Caribbean. This last task has been challenging not only considering the complications involved in building and analyzing panel datasets, but also due to certain peculiarities of the data in terms of availability and consistency.
American and Caribbean region we can find significant variations across countries and across time. For example, if we regard the level of private credit as a percentage of GDP (as an indicator of financial development) in the period 1970-2004, the lowest level value in the region corresponded to Haiti (4%) and the highest level to Panama (41%). For the period 2005-2009, St. Lucia is at the top of the region with a level of 95%, while Argentina is at the bottom with 12%3. But the Latin American and Caribbean region is not homogenous, either in terms of its financial systems or in terms of income levels, resource endowments, and development levels, among other aspects.
In light of this, and in order to exploit the maximum number of observations and the maximum level of heterogeneity across countries in the region, the present work covers practically all the economies of the region (around 30). Perhaps this fact could be a strong point in our study in relation to others (i.e. Nazmi, 2005; Blanco, 2007; Bittencourt, 2010) that also approach the case of Latin America but consider only 5 to 12 countries. Even in a very recent work (Venegas-Martínez & Rodríguez-Nava, 2014) that analyzes the finance-growth nexus for Latin America, only the seven higher-income countries of the region are considered4. Additionally, in order to exploit not only variations across countries but then also variations across time, we complement our pure cross-sectional analysis with a panel data analysis. By combining time series of cross-sectional units (i.e. countries), panel data models offer more data (despite a small number of observations), more variability, more degrees of freedom, and more efficiency.
Although a larger number of countries would be better and desirable in terms of heterogeneity and efficiency, we should also consider that a smaller sample of countries has its advantages. It is likely that by selecting countries of a specific region of the world or with similar economic condition (developed or developing), we could control better for some socioeconomic, cultural, geographical, and other conditions than when pooling countries from different regions or economic conditions. However, taking out such differences as developed-developing or African-Latin American and therefore focusing on a group of similar countries brings with it a cost in terms of losing variability. Nevertheless, such a loss of variability is relative given the existence of important differences across countries and across time within such a group (i.e. the Latin American and Caribbean region).
The study is organized into seven sections. In the one that follows this introduction, some theoretical considerations regarding the finance-growth and finance-inequality relationships are briefly discussed. An empirical review summarizing the existing empirical works published on both relationships is presented in Section 3. In the next section, we attempt to present somewhat of a condensed diagnosis regarding some indicators of growth, finance, and inequality in the region. In Section 5, the most important points in terms of methodology and data related with our research are introduced. In the sixth section, the main results of our data econometric analysis are presented for both relationships and considering two different econometric techniques (cross-sectional and panel data analysis). Then finally, we present the conclusions.
2.2 Theoretical Considerations
2.2.1 Theoretical considerations regarding the finance-growth relationship
Three hypotheses about finance and growth
Regarding the finance-growth nexus, Patrick (1966) labels two possible hypotheses between financial development and growth as the supply-leading hypothesis and the demand-following hypothesis. The supply-leading hypothesis states a causal relationship from financial development to economic growth. This effect is exerted by means of variations in productivity and capital accumulation. On the
3
Based on Beck and Demirgüç-Kunt (2012) dataset on finance indicators. 4
other hand, the demand-following hypothesis postulates a causal relationship from economic growth to financial development. So according to this hypothesis, financial development does not autonomously affect economic growth. On the contrary, economic growth gives place to an increasing demand for financial services that might induce an expansion in the financial sector5. Followers of this approach – among them Robinson (1952) and Lucas (1988) – argue that financial markets and institutions appear when needed. Therefore, if economies grow, business demand for financial services increases and the financial system grows in response6.
In addition to these two competing hypotheses, Patrick (1966) proposes the stage of development hypothesis. According to this hypothesis, supply-leading financial development can induce real capital formation in the early stages of economic growth. Innovation and development of new financial services opens up new opportunities for investors and savers and, in so doing, inaugurates self-sustained economic growth. As financial and economic development proceeds, the supply-leading characteristics of financial development diminish gradually and are eventually dominated by demand-following financial development. Surprisingly, there has been little empirical analysis of Patrick’s hypotheses, for either developed or developing countries (Calderon & Liu, 2005).
Regarding the supply-leading hypothesis, which seems the strongest in empirical terms, most of the literature points out that financial development causes economic growth by increasing productivity and capital accumulation. Additionally, empirical development economics shows that economic growth is mainly driven by productivity growth, rather than, as commonly thought, through capital accumulation. Indeed, an important way in which financial development could influence growth is by means of facilitating technological innovations and low-cost production methods that could increase productivity. First, the adoption of technologies requires large sums of capital that could easily be mobilized in well-developed financial systems. Second, well-developed financial systems encourage the adoption of long-gestation productive technologies by reducing investors’ liquidity risks. Finally, by providing hedging and other risk sharing possibilities, financial intermediaries and markets influence the assimilation of specialized and hence productive technologies. So countries with well-developed financial systems will experience larger productivity gains and therefore higher economic growth (Taddese, 2005).
Early theoretical contributions on the supply-leading hypothesis
With regard to the supply-leading hypothesis, the early quotations refer to Schumpeter (1912), Bagehot (1920), McKinnon and Shaw (1973) (as cited in Khan, 2000; Levine, 2004), and others. Schumpeter pointed out that the services provided by financial intermediaries such as mobilizing savings, evaluating projects, managing risk, monitoring managers, and facilitating transactions are important to give rise to technological innovation and consequently to achieve economic development. Bagehot argues that the distinguishing characteristic of English financial markets was the relative ease with which they were able to mobilize savings to finance diverse long-term and illiquid investment projects. This relatively easy access to external finance for firms was critical in promoting the implementation of new technologies in England and therefore may have a positive effect on economic growth (Khan, 2000).
The McKinnon and Shaw model
McKinnon and Shaw (1973) presented a financial repression model that stresses the negative effects of ceilings on deposits and loan interest rates. The fundamental argument is that financial repression in the form of interest rate ceilings would constrain financial deepening and consequently economic growth. An interest rate ceiling that gives rise to low or negative interest rates basically has two
5
Nicholas Stern’s (1989) survey of development economics does not even regard finance as a factor of economic growth. 6
negative effects. The first one relates to the reduction in savings and hence the amount of available loan funds that are intermediated through the financial system. The second negative effect would affect the marginal productivity of capital7. Financial intermediaries would not have incentives to ration credit based on marginal productivity considerations. So the most probable scenario is that they would ration credit according to their own discretion and this would impede the efficient allocation of investment funds. High reserve requirements and directed credit programs (which are also part of financial repression policies) further intensify these negative effects.
To summarize, the McKinnon and Shaw model regards financial repression as a disequilibrium phenomenon that prevents markets from clearing and serving their allocative function in an optimal way. Their policy recommendations would then be to liberalize the financial system and allow the market mechanism to determine the allocation of credit. Under this scenario, finance would have a positive impact on economic growth (Andersen & Tarp, 2003).
Enriching the contributions of Schumpeter, McKinnon, and Shaw, more recent theoretical works highlight the role of financial development as a promoter of growth. Early overviews of this theoretical literature are presented by Pagano (1993) and Levine (1997). These new theoretical considerations are based on endogenous growth models indicating that investment in research and development, in physical capital, and in human capital are major determinants of economic growth. Thus the core questions for growth are how to finance these investments and how financial intermediaries allocate funds (Gross, 2001). In this way, these theoretical considerations point to the channels linking finance and growth and the functions that are performed by the financial system8. Financial development will take place when financial intermediaries, markets, and instruments perform their financial functions well, influencing economic growth positively.
The Pagano model
For Pagano (1993) this positive effect of financial development on growth occurs mainly by means of three channels: the savings rate, the fraction of savings channeled to investment, and the social marginal productivity of capital. In order to capture these potential effects of financial development on growth, he considers a simple endogenous model, named the “AK” model. Pagano’s model is basically composed of four equations that make reference, respectively, to the determinants of aggregate output (equation 1) and gross investment (equation 2), the identity of saving and investment (equation 3), and the determinants of economic growth (equation 4).
Yt = AKt (1)
It = Kt+1 – (1-) Kt (2)
St = It (3)
g = A I/Y - = A s - (4)
In equation 1, the aggregate output is a linear function of the aggregate capital stock (AK). This production function is a reduced form of one of two frameworks regarded by Pagano. One is a competitive economy with external economies, where each firm faces technology with constant returns to scale but productivity is an increasing function of the aggregate capital stock Kt. In the other
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McKinnon in Chapter 6 of his book Money and Capital in Economic Development shows the case of Ethiopia. In this country the government capped the nominal interest rate on bank loans at 12% in order to clear the market for investment loans. Consequently, an arbitrary system of loan allocation arose whereby firms in strategic industries targeted by the government experienced excessive investment, which generated poor returns for savers. Additionally, farmers were unable to obtain short-term loans from banks. Instead, they had to borrow from informal money lenders who charge interest rates between 100 and 200% (Khan, 2000).
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framework, the AK model is obtained by assuming that K is composed of physical and human capital and these two types of capital are produced by identical technologies.
Additionally, in the model it is assumed that the population is stationary and that the economy produces a single good that can be invested or consumed. If this good is invested, it would depreciate at the rate of per period. So, the gross investment would be given by equation 2. In equation 3 the capital market equilibrium is reflected. Assuming a closed economy with no government, this equilibrium means that gross saving (S) equals gross investment (I). Additionally, Pagano assumes that a proportion of the savings (1-) is lost in the process of financial intermediation due to repressive interventions by the government.
The first step of equation 4 is obtained on the basis of equations 1 and 2. Its second step uses the capital market equilibrium conditions specified in (3), with the gross saving rate S/Y denoted by s. However, the most important fact of equation 4 is that it reveals how financial development could influence growth. Indeed, this last equation shows that financial development could have a positive effect on economic growth by means of three channels. These channels, as we already mentioned, are the proportion of savings funneled to investment (), the social marginal productivity of capital (A), and the private saving rate (s).
The main functions of the financial system
To organize a review of how financial systems affect savings and investment decisions and hence growth, a seminal and comprehensive paper by Levine (2004) focuses on five main functions provided by the financial system. These functions are the following:
To produce information ex ante about possible investment and to allocate capital To monitor investment and exert corporate governance after providing finance To facilitate the trading, diversification, and management of risk
To mobilize and pool savings
To facilitate the exchange of goods and services
Regarding the production of information and the allocation of capital, it is important to take into account that there are many costs associated with the evaluation of firms, managers, and market conditions before making investment decisions. Individual savers may not be able to collect, process, and produce this information. However, individual savers would be reluctant to invest in projects or activities with little reliable information. Therefore, high information costs may prevent capital from flowing to its highest value use. It is precisely because of this point that the role of financial intermediaries is important in reducing the cost of acquiring and processing information and consequently improving resource allocation. Without the existence of intermediaries, each individual investor would face large fixed costs when making investment decisions.
Greenwood and Jovanovic (1990) establish that financial intermediaries could have a positive effect on economic growth by improving information on firms, managers, and economic conditions. If we take into account that many entrepreneurs solicit capital and that this factor is scarce, financial intermediaries that produce better information would be able to fund more promising firms and induce a more efficient allocation of capital. Regarding this last conclusion, financial intermediaries may also boost the rate of technological innovation by identifying those entrepreneurs with the best chances of initiating new goods and production processes9. Additionally, stock markets would also encourage the production of information about firms. If we consider that markets become larger and more liquid, agents may have more incentives to expend resources getting information about firms.
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Indeed, for an agent who has this information it is easier to make decisions in the stock market (Levine, 2004).
With respect to the second function of the financial system, it is important to regard the effects of investment monitoring and corporate governance on economic growth. The degree to which capital providers can effectively monitor and influence how firms use that capital has implications on both saving and allocation decisions. If shareholders and creditors effectively monitor firms and induce managers to maximize firm value, the efficiency with which firms allocate resources will improve. Additionally, it will make savers more interested in finance production and innovation. On the contrary, without the existence of the financial system exerting a positive effect on corporate governance, there will be a significant limitation on the mobilization of savings for investment projects. Therefore, the effectiveness of corporate governance mechanisms has an effect on firm performance and consequently on economic growth.
Another important function of the financial system is the facilitating of trading, diversification, and management of risk. In this respect, Levine (2003) regards three types of risk: cross-sectional risk diversification, intertemporal risk sharing, and liquidity risk. With respect to cross-sectional risk, financial systems may relieve the risks related with individual projects, firms, industries, regions, countries, etc. Financial intermediaries and markets provide mechanisms for trading, pooling, and diversifying risk. The provision of these mechanisms can influence economic growth in the long run by affecting resource allocation and saving rates. While savers generally are risk-averse, high-return projects tend to be riskier than low-return projects. Therefore, if financial markets facilitate risk diversification for these agents, they would also tend to induce a portfolio shift toward projects with higher expected returns (Gurley & Shaw, 1995; Greenwood & Jovanovic, 1990; Saint-Paul, 1992; Devereux & Smith, 1994; and Obstfeld, 1994)10.
Regarding intertemporal risk sharing, the theory emphasizes the role of financial intermediaries in easing intertemporal risk smoothing. Long-lived intermediaries would lighten intergenerational risk sharing by making investments with a long-term perspective and offering returns that are relatively low in boom times and relatively high in slack times. Additionally, financial intermediaries would enable intertemporal risk sharing by reducing contracting costs.
The third component of risk, liquidity, would imply the costs and speed at which agents can convert financial assets into liquid cash at agreed prices. Liquidity risk increases because of the existence of uncertainties related with converting these assets into cash. These uncertainties are mainly related to the presence of asymmetric information and transaction costs that may restrain liquidity and consequently deepen liquidity risk. Therefore, the role of financial systems is crucial here for reducing these information asymmetries and transaction costs.
As we already mentioned, another important function of financial systems is the mobilization and pooling of savings. These actions involve the costly process of collecting capital from diverse savers with the purpose of supplying investment funds. Savings mobilization is mainly concerned with reducing the transaction costs related with collecting savings from different agents and overcoming the information asymmetries for savers who feel comfortable giving up supervision over their savings. Given the transaction and information costs related with mobilizing saving from diverse agents, multiple bilateral financial arrangements11 may be established in order to ease these frictions and facilitate pooling. To minimize the costs associated with multiple bilateral contracts, pooling may also take place by means of financial intermediaries. Through these intermediaries, numerous investors entrust their wealth to intermediaries that invest in numerous other firms. For this to happen, “mobilizers” have to convince savers about the quality and soundness of the investment (Boyd &
10
As cited in Levine (2004, p. 16). 11
Smith, 1992)12. With this purpose, intermediaries may work on building a good reputation to win the confidence of savers.
Finally, regarding the function of facilitating the exchange of goods and services, financial contracts can promote specialization, technological innovation, and economic growth by lowering transaction costs. In this respect, Greenwood and Smith (1996) identified some important links between exchange, specialization, and innovation. On this matter, we have to recognize that specialization requires more transactions. If we take into account that every transaction implies costs, financial contracts that lower transaction costs will stimulate greater specialization. Therefore, financial systems that promote exchange through decreasing transaction costs may encourage productivity gains and consequently may have a positive effect on economic growth.
This review of the functions of financial markets, institutions, and instruments suggests that well-functioning financial systems stimulate the level and quality of investment and therefore may have a positive effect on economic growth.
2.2.1.1 Undesired effects of financial development: Crises vs. growth
Diverse theoretical and well-known works (McKinnon, 1973; Shaw, 1973; Hicks, 1969; Merton, 1989; Pagano, 1993) refer to the positive role of financial development on economic growth. However, after the latest financial crisis this positive effect has been called into question. Some economists argue that the risk of crisis would increase due to an overly large financial sector. Others point out that an overly large financial system would take away resources from the “real” sector. Therefore, although financial development would be pro-growth, there is also the possibility that beyond a certain limit financial development does not contribute to growth anymore. On the contrary, as in the situation when a person eats too much, it is possible that above a certain limit finance becomes a drag for economic growth (Cecchetti & Kharroubi, 2012).
Although the recent crisis has raised concerns about the possible negative effects of financial development, we must be aware that this thesis is not new. Already before 2007, some theoretical and empirical studies such as those by Minsky (1974), Kindleberger (1978), Tobin (1984), Easterly et al. (2000), Rajan (2005) (as cited in Arcand et al., 2011), Ranciere, Tornell, and Westermann (2006), and others refer to this kind of threshold above which financial development has a negative impact on development.
Minsky (1974) and Kindleberger (1978) focused on the relationship between finance and macroeconomic volatility, referring extensively to financial instability and financial manias. In the case of Tobin (1984), he regards not only increasing volatility but also a suboptimal allocation of talents as consequences of excessive finance. The author states that social returns of the financial sector are lower than its private returns, producing the possibility that a large financial sector may take talent from productive sectors of the economy, giving rise to inefficiency from society’s point of view. For his part, Rajan (2005) shows the dangers of financial development and suggests that a large and complicated financial system had given rise to an augmented probability of a “catastrophic meltdown.” Easterly et al. (2000) use empirical research to show a convex and non-monotone relationship between financial development and growth volatility. Their findings even suggest that such a volatility of output growth starts augmenting when the ratio of credit to the private sector to GDP reaches 100% (Arcand et al., 2011).
However, the fact that a large financial sector may raise volatility does not necessarily mean that strong financial development is bad. There is a possibility that economies with large financial systems have to pay a price in terms of volatility but as compensation they will be rewarded with higher growth. This is precisely the main idea of the work of Ranciere et al. (2006) on the dual effects of
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